A few thoughts on nominal wage stickiness

Tyler Cowen recently responded to some wage stickiness comments by Bryan Caplan and myself:

But if people who work on commission and tips are out of work in large numbers, or if truly flex-wage workers are being laid off, why see wage stickiness as the #1 culprit?  (Scott isn’t following through the logical implications of his cyclicality point.)  In economies with truly flexible wages, people are forced to retreat into household production in down times and that is perhaps a better parable for America today.  No one will hire them, flexibility or not.  Plus if workers are irrational by focusing on the nominal rather than the real values, it’s easy enough to trick them by cutting real benefits and working conditions, thereby saving the employer money.  Real wage flexibility should be enough to keep them at work, yet it isn’t.

I have 5 comments on this passage.

1.  I don’t follow the logic of the last sentence.  First of all, nominal wage rigidity may be due to contracts, not money illusion.  But even if it is money illusion, Tyler’s argument doesn’t follow.  Just because a factory worker with limited skill at math doesn’t understand the distinction between a cut in nominal wages and a cut in real wages, does not mean that he wouldn’t realize if the assembly line sped up from 60 to 80 cars an hour.  And if he truly wouldn’t realize this, why hadn’t the car company already sped up the line?

2.  Just because aggregate nominal wage stickiness causes aggregate unemployment to rise, doesn’t mean wage flexibility in a single profession can prevent unemployment in that profession from rising during recessions.  There is a coordination problem here.  Suppose the money supply falls 10%, and all economic agents get in a room and immediately decide to cut all wages and prices by 10%.  Will it prevent recession?  We can’t be sure, but later I’ll argue that it will.  But if they don’t do that, then we will have a recession.  In that case most nurses will not lose their jobs even if they refuse to take pay cuts, and many factory workers will lose their jobs even if they take 10% pay cuts.  Nominal shocks cause recessions that have very different effects on cyclical and non-cyclical industries.  I believe that is a prediction of every important business cycle model.

3.  I agree that nominal wage flexibility plays no role in explaining the chronically high unemployment in certain economies.  The argument is that nominal rigidity explains why unemployment rises in the face of nominal shocks, and that’s all it explains.  I have no idea why Haitian businesses don’t cut wages when there are Haitians who are willing and able to do the same work for less.  Perhaps there is some sort of efficiency wage explanation.  In any case, the chronically high unemployment that one observes in certain developing countries, or even in some eurozone members, has nothing to do with nominal wage rigidity. 

4.  I don’t see “wage stickiness as the #1 culprit”.  Here is an analogy.  Suppose we observe engine failure once a month on jetliners.  Each time the plane crashes.  What’s the fundamental problem here, bad engines, or gravity?  Most people would say bad engines.  Now assume that every few years the Fed creates a negative nominal shock.  Because nominal wages are sticky, it creates a temporary recession (until wages adjust.)  What’s the fundamental problem here, sticky wages or monetary policy?  I’d say monetary policy.  To me, nominal stickiness is just a part of nature, like gravity.  It is not something you’d think about altering with government policies.  (BTW, it certainly isn’t the fault of “workers” most of whom don’t even set their nominal wage.)  Just as gravity is something airplane engineers must take into account, nominal stickiness is something that the Fed must take into account.  Of course there are government policies that increase real wage stickiness (minimum wages, extended IU benefits, etc) and those can make the problem worse.  At the risk of making my airliner analogy even more ludicrous, these rigidities are analogous to installing giant magnets on the ground, which try to suck airplanes out of the sky.  (Yes, I know that airplanes are aluminum.)

5.  Here’s why I can’t shake the idea that nominal wage (and perhaps price) stickiness is the key problem when AD falls.  Consider the 1920-21 deflation, which was quite rapid.  It was caused by a big drop in the monetary base (I believe around a 17% decline.)  Unemployment rose sharply, until wages had adjusted.  Now it seems to me that if these two facts are not related, if the rapid deflation (more than 20% depending on the index) did not cause the high unemployment in 1921, then I should just quit economics.  It would mean that everything I think I know is wrong–that I have nothing useful to say.  (Some people might wish I’d quit.)  But let’s assume I and the other 95% of economists who believe deflationary monetary policies increase unemployment are correct.  What then?  Well then explain this:  A few years back Mexico experienced 99.9% deflation almost overnight.  Prices plunged far more sharply than they did in the US between 1920-21.  And yet there was no sudden spike in the unemployment rate.  How could this be?  My theory is that Mexico avoided high unemployment during this severe deflation because the government ordered all nominal wage rates to be immediately cut by 99.9%.  Prices fell by a roughly similar amount (I don’t know if the government ordered them to fall.)  The point is that even severe deflation doesn’t cause additional unemployment if there is no nominal wage stickiness in the system.

Until someone can find a plausible alternative explanation for why America experienced high unemployment in 1921, but Mexico did not during a much more severe deflation during 1993, then I’m sticking with the sticky wage (and price) explanation of why nominal shocks have real effects.

One final point.  Once a major deflationary shock creates a severe recession, all sorts of real supply-side factors enter the equation.   I’ve already mentioned the cyclical effects of nominal shocks.  There is also the decision to raise IU from 26 weeks to 99 weeks—something that never would have happened without the initial nominal shock that created the recession.  But once those real factors kick in, the outcome can look very much like a real shock to a casual observer.  Don’t underrate the importance of unemployment benefits and other labor market rigidities.  The eurozone experienced long periods of near 10% unemployment (for reasons unrelated to nominal wage rigidities), there is no reason that it could not happen here—if we follow similar policies.

If the Fed boosts NGDP sharply, unemployment will fall sharply, Congress will let the extended IU benefits expire, and SRAS will shift right as AD is shifting right.  A win-win scenario.  Oh, and the budget deficit will automatically get much smaller.


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54 Responses to “A few thoughts on nominal wage stickiness”

  1. Gravatar of Ed Dolan Ed Dolan
    28. June 2010 at 09:29

    Scott–This is a very nice analysis of the sticky wage problem. It is going right into my readings file for my fall course in Riga. Latvia, in case anyone does not no, has embarked on a great national experiment (who says economics is not an experimental science) with what they call “internal devaluation,” by which they mean correcting an overvalued real exchange rate through decreases in prices and nominal wages while keeping the nominal exchange rate fixed. The experiment is far enough along now for it to be apparent that wages are not falling remotely as fast now (even with 20 percent unemployment) as they rose during the precrisis boom (20 percent per year, then).

  2. Gravatar of Ted Ted
    28. June 2010 at 09:54

    Haiti is pretty simple to explain:

    In early 2009 the Haitian government increased minimum wages from 70 gourdes per day to 200 gourdes per day. That is 185.7% increase! I have to think such a large increase would do something to the employment figures, particularly in such a poor country where is it still suffering from damage from the earthquake.

    Nice explanation of sticky wages though. I always had one speculative hypothesis of also why wages are inflexible in recessions, in addition to the standard ones. I really believe (based on limited work experience and common sense) employers tendency to maximize profits is business-cycle dependent. In the good times when profits are rolling in, you are more likely to become complacent and not exert the time and effort to determine your optimal firm size and reduce all those inefficiencies. When a nominal shock comes and you anticipate lower growth for your firm in the future, you begin to carefully examine and look around for “easy” ways to save money. All of a sudden, you realize that you let place get out of hand. You realize that Bob over there does absolutely nothing for your company, so you fire him because you didn’t need him even when the economy was expected to be good in the future. Or, if I upgrade to this new technology that is more productive I can let some of you people go because you’d be deadweight and I’d save myself more money. I think attention to profit maximization increases in business cycle troughs and possibly for a decent number of firms it becomes even unnecessary to cut wages (which is a painful negotiation).

  3. Gravatar of Indy Indy
    28. June 2010 at 10:15

    Is it really not true that there were some “real” factors, perhaps in the housing construction industry, contributing to this crisis? Is there a corresponding “sticky people” (human capital) theory of unemployment?

    There are perhaps a million middle-aged individuals who became, over many years, experts in some sector of the construction industry, and who are now very much out of luck (I happen to know a few). The demand for their expertise and skill has now evaporated, and there are far too many vacant and distressed properties to think about significant new building for some time to come.

    A discussion with one gentleman and his quest to find alternative employment gave me the impression that perhaps several million people’s skills, once quite valuable, are now worth little more than a low multiple of the minimum wage, and so these low-productivity jobs are overcrowded with applicants (and, yes, there’s also a lot of stubbornness and pride and terror at the prospect of a permanently lower quality of life involved).

    My instinct is to think something along the lines of “we over-invested and overbuilt in a frenzy of over-enthusiasm and over-optimism, attracted hundreds of thousands into a particular field, and now we’ve scrapped the value of their human capital and there’s little we can do about it in the short-term since human beings are often slow to change.”

    I realize this is perhaps a bit “Austrian” and potentially fallacious thinking. But it’s very tempting to think this way. What’s the essential error?

    Would slow and steady continuance in the rise of NGDP really have prevented this – or would we have needed something more dramatic and radical?

  4. Gravatar of jsalvati jsalvati
    28. June 2010 at 10:49

    I think Karl Smith’s notion of Price-Expectations Hypothesis is a pretty interesting idea. Thoughts?

    http://modeledbehavior.com/2010/06/28/whose-expectations/

  5. Gravatar of malavel malavel
    28. June 2010 at 11:27

    Could the mandated wage reduction that Mexico used be a solution for countries in trouble who can’t devalue due to the Euro?

  6. Gravatar of woupiestek woupiestek
    28. June 2010 at 11:46

    I have mentioned the effect of minimum wages on employment to some friends and family. It seems an effective way to make them say irrational things like: “without minimum wages all kinds of useless jobs would be created” (implying this is a problem for currently unemployed people) and: “all developed countries have minimum wages, so they must be good.” Do you have some clever replies?

  7. Gravatar of Doc Merlin Doc Merlin
    28. June 2010 at 12:49

    @woupiestek

    Not sure about the first one, but for this one:
    “all developed countries have minimum wages, so they must be good.”
    Switzerland, one of the richest per capita countries in the world, doesn’t have a minimum wage.

  8. Gravatar of Nick Rowe Nick Rowe
    28. June 2010 at 13:52

    1. Mexico. Do you really need mandated wage reductions when there’s a currency reform? Doesn’t the fact that there’s a clear focal point for a coordinated jump to the new equilibrium do the job just as well?

    2. Wage stickiness might play a partial role in determining the natural rate of unemployment in normal times as well. Suppose there are relative shocks to labour demand and supply that would require relative wage adjustment to keep labour markets clearing. If wages are slow to adjust to excess demand and supply, even if that slowness is symmetric, even in normal times there will be excess supply in some labour markets and excess demand in others, even if excess supply is zero in aggregate. And that could give us unemployment, even if the supply equals demand in aggregate. (I’m harking back to Lipsey’s old 1960′s model of the Phillips curve.)

  9. Gravatar of Keith Eubanks Keith Eubanks
    28. June 2010 at 14:46

    Scott,

    Q1:
    In your estimation, what is the time lag between the fed increasing the money supply and prices adjusting? wages?

    In the 1930s when the dollar was devalued in terms of gold, real prices and wages were effectively cut overnight, but I don’t see the fed as having that kind of handle today?

    Q2:
    Friedman and Schwartz comment about how the deposit currency ratio stayed low during ww1 and inflation didn’t really hit till the war ended (I believe they indicated about 5% of Federal revenues during the war came from the printing press). In their book, Friedman and Schwartz indicated their explanation was lacking. Is there an accepted explanation today?

  10. Gravatar of Lorenzo from Oz Lorenzo from Oz
    28. June 2010 at 15:39

    woupiestek: for the first one, if someone is willing to pay for the job and someone else willing to do it, how is it “useless”?
    Further, how can a job be more useless than unemployment?

  11. Gravatar of Lorenzo from Oz Lorenzo from Oz
    28. June 2010 at 16:02

    Ted: the premium on economic efficiency shifts in public policy, so that it might shift for firms is not such a big ask.

  12. Gravatar of Morgan Warstler Morgan Warstler
    28. June 2010 at 16:18

    “If the Fed boosts NGDP sharply, unemployment will fall sharply, Congress will let the extended IU benefits expire, and SRAS will shift right as AD is shifting right. A win-win scenario. Oh, and the budget deficit will automatically get much smaller.”

    Ok, so your method of boosting NGDP is to go buy a ton of treasuries off the bond holders.

    I assume you intend the bond holders with this new loot will be driven to buy something else (invest) besides more treasuries.

    Why? What causes them to go invest elsewhere?

  13. Gravatar of Doc Merlin Doc Merlin
    28. June 2010 at 16:54

    @ Keith Eubanks
    Re: Q2
    There is a heterodox explanation.
    According to Austrians, the price inflation in consumer markets doesn’t immediately coincide with monetary expansion.

    It affects financial and capital markets first (because thats where the money is going first), then consumer prices increase, then you get a massive crash in consumer prices because of excessive production at the same time as you get a financial crash.

    We see evidence of this by looking at PPI and CPI data around ww1. PPI shoots up very quickly and it takes a while for CPI to catch up.

  14. Gravatar of StatsGuy StatsGuy
    28. June 2010 at 19:37

    The post above does not quite answer TC’s challenge:

    “why see wage stickiness as the #1 culprit?”

    To argue merely that sticky wages is a problem, and there are historical examples where it was a serious problem, does not make it the #1 culprit. You need to argue it’s more important than other problems.

    There are are least 2 narratives here: the #1 problem is sticky wages, and the #1 problem is debt. Consider these two competing hypotheses, Kuhn-style. There may be more hypotheses (e.g. liquidity freeze due to the credit channel, if you believe it, or deep structural problems due to trade or oil prices or demographics…).

    [Moreover, from a very practical viewpoint, even if basic wages fell very substantially, it becomes increasingly less important in terms of making new hires in a modern economy - even without regulation, the costs of hiring and training someone, and the overhead of providing them with equipment and space, and buying insurance to cover their actions, and the time it takes to bring them up to speed, and the harmful impact on the organization and morale when new employees aren't kept busy - mean that even "free" employees are costly. The savings from a 5% drop in wages paid out are far less than 5% of the total real cost of hiring an employees.]

    One might argue that a 5% drop in wages would increase firm profitability even if it did not translate into more hires at the margin, and that this new profitability would lead firms to spend more on investments. However, firms have seen excellent profits over the past year, and they are simply not hiring. They have plenty of cash, but they are not investing heavily. If anything, they are looking to stay lean, and continuing to shed jobs as they can. At no point do we observe firms complaining that the reason for not hiring is because wages are 5% too high; they complain there is not enough demand, or they might complain they can’t find the skills/talent they want.

    Here’s another thought experiment for you:

    If you were to cut all wages by 70% across the board in nominal terms, but leave nominal debt intact, would the economy suddenly recover? OTOH, if you were to cut nominal debt by 70%, but leave nominal wages intact, would the economy suddenly recover? In the former case, I suspect there would be a _lot_ of bankruptcy and liquidation for many years.

    It is entirely plausible that in most situations dropping wages is stimulative, but that in some situations the drop in incomes dominates the increase in employment and profits – and one might imagine debt plays a role here.

    I rather strongly suspect that the reason Austrians are enjoying a resurgence is because they agree with “common sense” that debt (including future transfer obligations) is _the_ problem, while keynesians and monetarists disagree (for different reasons). Indeed, both Keynesians and Monetarists want more debt – the difference being that Keynesians want public debt and monetarists want to force private debt.

    The fundamental question Austrians should be trying to answer is, what is the mechanism by which debt causes a marshallian economy to break? Where, precisely, is the slippage, if it’s not “sticky wages”? I’m not sure if I’ve seen a formalized argument about where the slippage occurs.

  15. Gravatar of Philo Philo
    28. June 2010 at 20:48

    You ask: “What’s the fundamental problem here?” Perhaps this means: Which necessary causal factor (in producing the bad result) would be most readily (i.e., at least cost) avoided by different human action(s)?

    Such an interpretation seems satisfactory so long as the topic is recession: U.S. monetary policy looks to be “fundamental,” since it is controlled by a handful of Fed officials, who could very easily behave differently. (Even here, the blame might better be put on the U.S. President[s]: he [they] could very easily have appointed other officials who would have behaved differently.) But your discussion seems aimed at greater generality, so let’s look at a different problem: crime (theft, murder, etc.; i.e., *real* crimes, not drug possession, etc.). The least costly way not just to reduce but to *eliminate* crime is for *criminals to refrain from committing* crimes. Now, that’s not a very useful (“pragmatic”) observation, so perhaps you would not grant that the “fundamental problem” of crime is *the voluntary actions of criminals*. What *is* your view about this?

    You hint that you won’t consider a causal factor to be “fundamental” unless it can be “alter[ed] with government policies.” Is the government, then, the only “fundamental” agent? That doesn’t fit your airplane-crashes example.

  16. Gravatar of Bob Murphy Bob Murphy
    28. June 2010 at 21:13

    But Scott, didn’t nominal wage rates fall by 20% or so in the 1920-1921 depression? So yes, nominal wage rigidity leads to temporary unemployment, but the market quickly resolves it. So massive Fed injections of liquidity aren’t the solution.

  17. Gravatar of Ken Ken
    29. June 2010 at 04:03

    Hi Scott,

    I’m confused: aren’t you ignoring the fact that the Mexican introduction of a “new peso” did not increase the real quantity of debt in the country? In other words, isn’t debt-related issues a second big factor that could differentiate your two examples?

  18. Gravatar of scott sumner scott sumner
    29. June 2010 at 05:14

    Ed, Thanks. I agree that it is extremely hard to fix inadequate AD (or inadequate NGDP) through lower wages. Much easier to inflate/depreciate.

    Ted, Thanks for the Haiti info.

    Regarding cost savings; I think some of that does occur, once sticky wage cause real sales volumes to drop.

    Indy, You said;

    “Is it really not true that there were some “real” factors, perhaps in the housing construction industry, contributing to this crisis? Is there a corresponding “sticky people” (human capital) theory of unemployment?

    There are perhaps a million middle-aged individuals who became, over many years, experts in some sector of the construction industry, and who are now very much out of luck (I happen to know a few)”

    Yes, there was a real problem, but it was fairly small. Most of those jobs were lost between mid-2006 and mid-2008, and most workers found jobs elsewhere, as unemployment was fairly low. Only when NGDP started falling in late 2008 did unemployment become a major problem.

    jsalvati, If I understand him correctly, that is a different way of describing some ideas I’ve been kicking around. If you can’t point to rising TIPS spreads, you have no business worrying about inflation. Have I interpreted him correctly?

    Malavel, You could try, but there’d probably be riots in the street. Here’s the difference. Mexico faced a nominal shock in 1993 (aka currency reform) and no real shock. Greece also faces a real shock, and needs both lower nominal wages and lower real wages. That is much tougher.

    woupiestek, See Doc Merlin. In addition, I vaguely recall that until a couple years ago Germany and Britain lacked a minimum wage. But everyone would consider Germany or Britain circa 1996 to be developed countries with high living standards. Can someone confirm if my memory is correct?

    Thanks, Doc Merlin.

    Nick, Yes, you are probably right. But suppose some labor contracts had gotten out of line, and the business (but not workers) wanted to tear it up. The company could use the currency reform as an excuse to walk away from contractual obligations. The best example of this is obviously debt contracts, no focal point would fix those w/o government intervention.

    2. That’s a good point about the natural rate–I had never thought of that.

    Keith, Q1, The time lag varies on a number of factors. Commodities react immediately. So do exchange rates and some import prices. Other goods take months or even years to fully adjust, but generally adjust faster when central banks have very high inflation policies.

    The term ‘real prices’ is ambiguous, but yes, real wages fell right way. The equivalent policy today would be a higher price level of NGDP target, level targeting.

    Q2, Sorry, I can’t answer the WWI question.

    Lorenzo, I agree.

    Morgan, You said;

    “I assume you intend the bond holders with this new loot will be driven to buy something else (invest) besides more treasuries.”

    Perfect illustration of the fallacy of composition. As individuals we can all buy more Treasuries, as a group we (non-Fed public) can’t. There are only so many Treasuries. In any case, even if we got them from China, or the moon, the Chinese and Moonmen wouldn’t want to hold Federal Reserve notes. It’s a hot potato.

    Statsguy, You said;

    “To argue merely that sticky wages is a problem, and there are historical examples where it was a serious problem, does not make it the #1 culprit. You need to argue it’s more important than other problems.”

    I thought I made it clear that I agree with Tyler, it is not the #1 problem. I view tight money as the number one problem. To the extent that non-monetary factors are to blame for the recession (as Tyler believes) I certainly would concede that wage stickiness is not the problem. But without wage (and price) stickiness, I don’t see how nominal shocks have real effects (they didn’t in Mexico.)

    You said;

    “Moreover, from a very practical viewpoint, even if basic wages fell very substantially, it becomes increasingly less important in terms of making new hires in a modern economy – even without regulation, the costs of hiring and training someone, and the overhead of providing them with equipment and space, and buying insurance to cover their actions, and the time it takes to bring them up to speed, and the harmful impact on the organization and morale when new employees aren’t kept busy – mean that even “free” employees are costly. The savings from a 5% drop in wages paid out are far less than 5% of the total real cost of hiring an employees.]”

    This paragraph is just a roundabout way of saying price stickiness is also a problem. I agree. You’d need both wages and other factor prices to fall 10% in the face of a 10% drop in M, in order for money to have no real effects. I just happen to think that wage stickiness is the bigger problem.

    Regarding debt, I have two answers. Financial distress does not seem to be a big problem in most recessions, so I think sticky wages and prices are the more robust transmission mechanism. And second, being unable to repay debts doesn’t cause someone to want to work less. We are trying to find out why Say’s Law doesn’t work. Wage and price stickiness can explains the breakdown in Say’s Law, I don’t see how debt gets you there. Economists have tried to come up with debt models for unemployment, but it is not easy.

    There’s also an ambiguity in your comment. Are you saying debt explains the fall in NGDP, or that it explains why a given fall in NGDP showed up more as Y and less as P? In my model sticky wages don’t explain why NGDP fell, rather they explain why a given fall in NGDP also reduces Y.

    Philo, You said;

    “You ask: “What’s the fundamental problem here?” Perhaps this means: Which necessary causal factor (in producing the bad result) would be most readily (i.e., at least cost) avoided by different human action(s)?”

    Yes, that’s exactly my view. In general, the concept of causation is extremely subjective. The best way of thinking about a given problem will depend on the situation. I used the airplane example because I thought almost everyone would agree with me in that case, so I could therefore explain my state of mind regarding wages. I didn’t use it to prove I was right, but rather to explain to others why I think workers are not the fundamental problem. I’d have to think about crime. Criminals take an affirmative step to create crime. A worker who takes a job at Ford doesn’t take an affirmative step to create aggregate nominal wage stickiness.

    Bob, If you deflate nominal wages by the WPI, then real wages rose in 1921 by the largest amount in the 20th century. It perfectly fits the sticky wage model. Unemployment soared. Then wages adjusted, again perfectly fitting the model. Unemployment fell rapidly. Again, perfectly fitting the model.

    Ken, Yes, but see the part of my response to Statsguy that starts out “regarding debt.”.

  19. Gravatar of Ken Ken
    29. June 2010 at 06:00

    I’m still a relative beginner, but it seems obvious to me that debt in the presence of significant deflation creates unemployment because it requires significant reallocation of resources to deal with the need for significant financial restructuring. I’d love some recommendations on readings to help better educate me on what I am missing.

    Meanwhile, in general, I think Scott’s use of the Mexican introduction of the New Peso is not really relevant. It’s not really an example of deflation since the real value of money was not increased.

  20. Gravatar of Keith Eubanks Keith Eubanks
    29. June 2010 at 06:13

    @Doc Merlin,

    Thanks.

    I have a follow-up on Q2 and this gets more to what I’m curious about.

    According to Friedman and Schwartz gov expenditures during the timeframe of WWI were financed with roughly 25% taxes, 70% borrowng and 5% printing.

    I assume with that level of borrowing for the war, the government was pulling in a very large share of the nation’s savings. Hence, a moderate portion of US savings would have been going into non war related investments; one could guess that net investment for the nation would have been close to zero (at least substantially lower than pre-war). With low levels of net investment, I would assume that underlying growth was slowed, and that the nation’s ability to grow deposits would have been slowed too. F&S comment about the “sizable decline” in the deposit currency ratio.

    Once the war is over, investment to other areas would have returned with the reduction in war borrowing and spending. Deposits would grow briskly.

    In the civil war, green backs financed a large portion of the war and inflation was strong during the war. For WWI (&II), borrowing played the predominate financing role. I’m wondering if government borrowing can constrain inflation in this situation because in a war financed through borrowing you are shifting the bulk of a nation’s savings toward consumption spending and away from investing in other productive endeavors (I assume bullets, bombs, planes, soldier salaries, etc. are predominately consumption type activities). You are effectively putting the brakes on non war related industries/activities by re-directing savings toward the war. I assume this would hinder the ability to grow deposits — the bulk of the money supply, and slow the development of infation until wars end.

    Any thoughts? Reasonable or wacko?

  21. Gravatar of StatsGuy StatsGuy
    29. June 2010 at 06:23

    ssumner:

    “I thought I made it clear that I agree with Tyler, it is not the #1 problem.”

    Fair enough. Apologies.

    “But without wage (and price) stickiness, I don’t see how nominal shocks have real effects.”

    That is the problem, isn’t it? And I don’t see the austrians putting forward a formal explanation of how debt causes the breakdown either, even though I do think keynesians and monetarists understate the problems with debt. Somne austrians will talk alot about how aggregates aren’t aggregates, which is essentially saying real aggregate demand doesn’t matter because aggregate demand is a mythical construct. Others talk about a reduction in future spending power, but this reduction for some implies an increase for others. So where is the slippage? Is it really just an expectations problem? (people get scared by debt, fear it can’t keep growing at an accelerating rate, and don’t invest?). Are we confusing structural problems (aka, social security and health care future obligations) for nominal debt problems? Maybe.

    Here, I think are, three other possible slip points:

    1) Wealth distribution and non-linearities in spending/consumption curves. As wealth is shifted by changes in asset prices & interest rates, it’s shifted from people who tend to borrow to finance asset purchases and expenses, to people who tend to save and lend. This shifts net real wealth (the allocation of future consumption rights) to people who don’t consume as much. This shift in wealth is also accompanied by a shift in political influence and perceptions of predictive accuracy about social mechanics. (Another way of saying the doomsayers gain wealth and exposure on CNBC simultaneously, which gives them greater leverage to reign in the Fed.)

    2) Leverage amplification, threshold effects, and transaction costs for reallocation of resources. When debt levels are high relative to net assets, a small change in asset value can throw an entity into insolvency. This allows a relatively smaller change in expectations to amplify into a large drop in net value. Let’s say in 2008, the world suffered a _permanent_ drop in nominal expectations when it observed that the US Fed faced more challenges in carrying through its promises than they had expected. Everyone suffers a small but real long term increase in preference for liquidity. In a highly leveraged environment, this small increase is amplified massively. In a low debt environment, a small increase is more easily tolerated.

    This amplified increase in preference for liquidity sees asset values drop below debt values due to extreme leverage (e.g. the US housing market, and the LBO market, etc.), and we observe three things: people who owe debt reduce expenditures, and real purchasing power is thus transfered to lenders. Lenders inherently have reduced expectations for growth, and higher liquidity preference, which translates into a shift in the aggregate preference for liquidity (part 1 above). Second, insolvencies and unemployment materialize. Even in the absence of price stickiness in non-debt, insolvencies and unemployment create massive transaction costs. This is somewhat like Kling, except Kling believes most of this friction is ultimately functional (rather than cyclical) and so can’t be stopped by monetary policy. Three, normal people and firms – expecting all of this to reduce future demand, cut investment, and this feeds back into the cycle above.

    3) sticky wages and prices – with the caveat that non-wage labor costs (other prices) are growing. This caveat is important because talking about wages implies that the way to fix the problem is dropping nominal wages without changing other variables – which I think is not necessarily true (and, Tyler Cowen seems to think so too).

    In a sense, it’s a belief problem – but it’s not a pure belief problem, because the underlying factors driving belief are real (increased preference for liquidity, transfer in social power to savers and pessimists, real frictional costs, and the awareness that structural debt is causing all of these to intensify into the future).

    The flaw in the neo-keynesian approach is that even if we could establish credibility of the monetary authority, the markets believe that future actions would become unsustainable due to debt growth placing real stresses and risks, and thus the _system_ isn’t credible. That is the argument made by bloggers like ZeroHedge, and many other doomsayers, and we ignore it at our peril. Even the belief alone in unsustainability can shake the system.

    Reflation needs to be accompanied by a sustainable structural debt path. But political gridlock is preventing the grand bargain that needs to happen.

  22. Gravatar of Bob Murphy Bob Murphy
    29. June 2010 at 06:36

    Bob, If you deflate nominal wages by the WPI, then real wages rose in 1921 by the largest amount in the 20th century. It perfectly fits the sticky wage model. Unemployment soared. Then wages adjusted, again perfectly fitting the model. Unemployment fell rapidly. Again, perfectly fitting the model.

    Yes it fits the model, but not the policy conclusion. You are saying we need the Fed to inflate, because otherwise we’ll be stuck with high unemployment for who knows how long.

    And I’m saying nominal wages dropped by 20% in a year, back then. So we don’t need massive injections of new base money in order to prevent a really long depression. If you leave the market alone (or better yet, massively cut gov’t spending and tax rates too while you’re at it), the market will fix itself in a year.

    Just like happened in 1920-1921.

  23. Gravatar of Morgan Warstler Morgan Warstler
    29. June 2010 at 07:17

    “Perfect illustration of the fallacy of composition. As individuals we can all buy more Treasuries, as a group we (non-Fed public) can’t. There are only so many Treasuries. In any case, even if we got them from China, or the moon, the Chinese and Moonmen wouldn’t want to hold Federal Reserve notes. It’s a hot potato.”

    I made no such assumption, I instead assumed that the new demand for Treasuries would drive down rates, and lead guys like Krugman to scream we can obviously afford more Federal debt spending. Which is bad.

    ——

    Question: Why not instead have the Fed take all the toxic MBS they have purchased, unwind them to identify all the foreclosed assets, and have an immediate nationwide auction for approved credit buyers bringing 30% to table – Fannie and Freddie do not get to participate…

    Overnight we become a nation of renters.

    This empties out the non-performing assets, resets prices to their correct place… the Fed takes one big hit on its balance sheet – and whatever it’s loses on its balance sheet, it can always print more money if it needs to later.

    The construction industry climbs back to new normal, as the rental properties need fixing up.

    Foreclosed homeowners newly displaced are now mobile to find work elsewhere.

    Guys with capital are back in the game, momentum is rolling forward.

    I don’t see a downside.

  24. Gravatar of JimP JimP
    29. June 2010 at 08:28

    The markets get hit. Krugman says we are on the edge of a depression.

    Obama meets with Bernanke.

    And what happens?

    Exactly nothing.

    Obama drones on and on about stuff we don’t need – energy and finreg – while Bernanke sits there looking terrified – like a deer in the headlights. Waiting for the moron President to stop talking so he can get back to not being able to do anything with monetary policy because the moron President hasn’t said anything at the meeting and also has not given him the votes on the board that he needs.

    Charming.

  25. Gravatar of JimP JimP
    29. June 2010 at 08:37

    I guess this is what this administration calls turning a crisis into an opportunity. The markets get crushed – so lets pass finreg. And I thought Bush was a moron. But Obama takes the prize.

  26. Gravatar of JimP JimP
    29. June 2010 at 18:19

    I am sorry i called Obama a moron. He is not that. Bush was. But Obama somehow is not grasping what is right in front of his nose.

    That is what Bob Herbert is saying here and I think he is right.

    http://www.nytimes.com/2010/06/29/opinion/29herbert.html?scp=2&sq=bob%20herbert&st=cse

  27. Gravatar of Bonnie Bonnie
    29. June 2010 at 20:16

    I understand the basic argument, at least I think: If the Fed boosted NGDP unemployment would be reduced. But what if it doesn’t do that – which it seems to have little inclination of doing? What can Congress do about it besides spend us into oblivion, which doesn’t seem to be working? I’m not sure that Congress has a clue about what’s going on. If it had a clue my guess is that given this is an election year the congress critters would be relentlessly hounding the Fed and I’m not seeing that, not publicly anway.

    Then I have another question: And then what? Suppose the Fed announced tomorrow that it would put X number of dollars into the economy and leave it there unless inflation becomes a real problem. Wouldn’t that help only short-term? Does NGDP tageting as a policy make it more of longer term fix?

  28. Gravatar of Bonnie Bonnie
    29. June 2010 at 20:34

    I don’t mean to bomb your comments section but I thought of another question about the 1920 depression. I seem to recall that Warren Harding was left to deal with that. He and congress cut the marginal tax rate from 75% to 25% and took a big chunk out of Federal spending. Do you know if there was any corresponding Fed action?

    Economist Benjamin Anderson writes, “In 1920–21 we [the U.S.] took our losses, we readjusted our financial structure, we endured our depression, and in August 1921 we started up again. . . . The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good.”

  29. Gravatar of Doc Merlin Doc Merlin
    29. June 2010 at 21:20

    @Bonnie
    The Fed increased the monetary base at the beginning of the recession then drastically cut it about half way through. By the end of the recession, the monetary base was cut about 15% from the peak and lowered about ~7% from the beginning of the recession. In short, bonnie the fed mostly used contractionary monetary policy during the recession.

    The federal government cut federal spending massively as well during the recession as you explained. Then if you want to use Hydraulic Keynesian models marginal propensity to consume must be greater than one. This results in the strange result of tax cuts being bad for the economy, and spending cuts being good for the economy. This is a strange result, and I don’t really believe it… I’ll have to think more about it.

    The recession of 1920 is an odd case, It doesn’t just hurt the cause of the pro-fiscal stimulus folks, it also looks bad for those who think monetary policy can end recessions (like Scott and most of the posters here). Really, it looks best for the RBC folks. It is a really interesting recession and one which I should study further.

  30. Gravatar of Doc Merlin Doc Merlin
    29. June 2010 at 23:44

    @Keith

    My intuition is that excessive fiscal spending should help NGDP but hurt GDP by causing misallocations. I’m not sure if your proposal would work, I’d like to look at it more deeply.

  31. Gravatar of Alex F. Alex F.
    30. June 2010 at 02:32

    I think Statsguy nailed it. It’s about debt. People hate more debt. Be it public or private. So why can’t we have monetary policy without debt?

    As I understand this, it’s all about belief. Raising expectations. The goal is to get markets to expecting ngdp to grow 5% percent. So why not engage in some unconventional quantitative easing?

    Let say the president addresses the public: “Dear Americans, you underprice yourself causing Deflation, Depression, Unemployment… Ngdp growth under 5% is un-American. We have do believe in ourselves. I believe in you, the Fed believes in you. To fight another depression, the Fed will therefore stimulate the economy (not by buying any debt or forcing people to go into debt) but by buying the “goodwill” of each and every American. Everybody gets for his “goodwill” each month a check from the Fed until we have 5% ngdp growth expectations.”

    The Fed just writes down on its balance sheet: bought “goodwill” of 300 million Americans.

    If we get too much ngdp growth the Fed devalues the “goodwill” by tightening the money supply. If ngdp falls again, the Fed raises the value of “goodwill”, sending checks to each American. No debt involved.

    Sure, “goodwill” works just like a helicopter drop financed through selling government bonds but it looks and feels different since no debt is involved. It’s like a gigantic debt-equity-swap. It’s a way to monetize expectations. Treating expectations as an asset. Paying people to be optimistic when ngdp is down, letting them pay when they are over-optimistic and ngdp is too high. A bit like treatment of bipolar disorder:-)

    Could this work?

  32. Gravatar of DanC DanC
    30. June 2010 at 03:26

    Scott
    Is Ireland a model that shows that flexible wages and loose monetary policy – rather then government spending – is the quickest way to recover from an economic turndown?

  33. Gravatar of scott sumner scott sumner
    30. June 2010 at 05:21

    Ken, The real value of money increased 1000-fold in Mexico.

    Deflation is very contractionary even w/o debt. Does debt make it more contractionary? Perhaps, but I am having trouble understanding why. Why should debt make people want to work less? It might cause some reallocation or resources, but I don’t see that as having a major cyclical effect.

    Keith, I am not certain. I seem to recall that F&S argued that inflation was low during both world wars because growth was high. They were essentially using the MV=PY equation, where higher growth, ceteris paribus, lowers inflation.

    Statsguy, Those are actually several different arguments. You begin with some speculation about how and why we ended up with a monetary policy that sharply slowed NGDP growth. Then you sharply shift gears:

    “Even in the absence of price stickiness in non-debt, insolvencies and unemployment create massive transaction costs. This is somewhat like Kling, except Kling believes most of this friction is ultimately functional (rather than cyclical) and so can’t be stopped by monetary policy. Three, normal people and firms – expecting all of this to reduce future demand, cut investment, and this feeds back into the cycle above.”

    Now you are talking about something closer to hysteresis–once unemployment gets high, it gets stuck at high levels due to some real factors. If so, I have some sympathy for that argument. And I think where you and I agree, and where Kling doesn’t agree, is that monetary policy can do something about that problem. Let’s suppose unemployment is stuck at high levels because:

    1. Recent minimum wage increase
    2. Extended UI benefits
    3. Debt burdens, as you discuss

    All of those problems become less severe with expansionary monetary policy. In the case of 1 and 3 it happens automatically, in the case of #2, Congress is likely to reduce the duration of UI if unemployment falls significantly. So more AD can improve the supply side of the economy. It is the start of a “virtuous circle.”

    Bob, We probably both agree that the supply-side is not as good as in 1921. We have 99 week UI benefits, we have a big recent jump in the minimum wage. I am saying that more AD will also pressure Congress to go back to 26 weeks of UI, and make labor markets more flexible. But the big difference from today is that NGDP grew very fast in 1922.

    I agree that we probably don’t need massive injections of base money (although I’d do it if we needed it.) Then we had the gold standard, today we need a price level or NGDP target.

    Morgan, But if we get an economic recovery, Congress won’t be pressed to do the wasteful stimulus, regardless of interest rates. The only reason we had the huge stimulus was that tight money gave us a severe recession.

    JimP, I agree.

    Bonnie, NGDP targeting does not solve long run problems, it is designed to get us out of recession.

    I agree that Harding did an excellent job in 1921-23. He followed relatively laissez-faire policies, cutting taxes sharply. There were no 99 week UI benefits or minimum wage increases. The supply-side was very flexible. In contrast, Hoover did everything wrong.

    Doc Merlin, You said;

    “The recession of 1920 is an odd case, It doesn’t just hurt the cause of the pro-fiscal stimulus folks, it also looks bad for those who think monetary policy can end recessions (like Scott and most of the posters here). Really, it looks best for the RBC folks. It is a really interesting recession and one which I should study further.”

    I strongly disagree with this. Monetary policy was quite expansionary. Between 1921:4, and 1923:1, NGDP grew by 20.4% over a period of 5 quarters, or just over a year. That shows that fast NGDP growth produces fast recovery. (I used Gordon and Balke estimates, but any other data would show a similar story.) We need faster NGDP growth to get a faster RGDP recovery.

    And if anything, the difference from today is even more dramatic than those numbers suggest, as the normal NGDP growth rate back then was closer to 3%.

    Alex, That would work, but there are easier ways to get the job done. That would also increase the national debt, as taxes would have to be raised to pull some of that money out when a recovery occurred.

    DanC, I am not sure I follow your Ireland example. They are in the euro, and thus have tight money. I don’t think either flexible wages or government spending are very good ways to recover.

  34. Gravatar of dlr dlr
    30. June 2010 at 06:16

    Scott, two questions.

    (1) Related to you hysteresis comment to Statsguy. I haven’t been able to tell is if you actually think the extended period of unemployment (in contrast to the initial shock) has in fact been due to real factors like you list or is still primarily an AD problem. And if it is an AD problem is it an actual “excess demand for money problem” or is it a problem of relative prices (wages) being out of whack from the initial shock? Alan Rabin’s Monetary Theory book that was supposed to be written with Yaeger spends a lot of time talking about how economies can get stuck in a quasi-equilibrium where the AD is not necessarily still declining b/c there is no excess demand for money at the new, lower level of output/income, but money supply is still inadequate to the hypothetical (notional) demand for money at full employment. Do you buy that?

    (2) I apologize that this is off topic for this post — ignore at will. About a year ago you did a couple of nice posts on why you don’t find the IS/LM framework particularly useful. I was recently rereading Bernanke’s 2002 famous deflation speech where he notes as an aside that his preferred solution to the zero bound problem is to announce a cap on longer term treasury rates. This rate-centric view seems to reflect the biggest disconnect between the way you think and the way that Academic Bernanke and, say, Woodford think. I read Interest and Prices but I still can’t get myself to answer this question: Why would they (Woodford or Academic Bernanke) say you are less helpful in the way you focus almost exclusively on the relationship between the expectations that influence money supply/demand and nominal spending as opposed to the interest rate channel? Do they ultimately make some kind of micro-assumptions about the demand for money that gets in the way of using the excess cash balance mechanism that you like?

  35. Gravatar of Morgan Warstler Morgan Warstler
    30. June 2010 at 07:05

    “Morgan, But if we get an economic recovery, Congress won’t be pressed to do the wasteful stimulus, regardless of interest rates. The only reason we had the huge stimulus was that tight money gave us a severe recession.”

    Wait, this directly contradicts without explanation MY WHOLE POINT. The true cause of our situation is two fold: Bad Fiscal Policy made worse by Bad Monetary Policy.

    You as a monetarist WANT DESPERATELY to have the glaringly obvious errors of FP glossed over by MP. I give you examples…. and you scream, “no I hate the way government spends money!” But then you go about your day working to solve for it with a printing press.

    You somehow forget the obvious implication, that we KNOW FOR SURE Fiscal Policy is bad. Monetary policy – no one is certain. Logic suggests then that ONLY good Monetary Policy is that which forces us to fix Fiscal Policy. But you refuse to engage serious discussion on this.

    In an Ayn Rand novel, you are the character desperately trying to keep the train on the tracks. But this isn’t an Ayn Rand novel, we have tens of millions of educated likely voters prepared to gut Public Employees and raised age on benefits, trim sails on military, and FORCE Obama to make like Clinton – and balance the budget.

    BUT dude, the economy has to be in the shitter and the debt has to be crushing us – and then Obama will bend.

    And the quickest way for that to happen is for rates on T-Bills to go up, and prices to fall, so that:

    1. 33 cents on every dollar of taxes is paying off debt. This forces wholesale changes in Fiscal policy. DO NOT WORRY! Taxes will not go up. The ethos of Governor Christie in NJ will triumph.

    2. Prices on real estate fall. Yes, yes you are concerned with “price levels” not real estate – this is a bogus concern – in many families 40% of income is going to artificially high mortgage payments… many more people need to put their keys in the mail box and become renters. When they do so, they will have more money to spend elsewhere in the economy. They will move to get a job. I’m unable to get concerned about deflation, jesus if the price of oil goes up, prices in every sector will increase overnight.

    Scott, is there EVER a time where you stop and imagine that perhaps the only way to force changes in FP, is to stop screwing around with MP?

    I know you only have a hammer, and this blog is about hammer policy, but jesus MACROECONOMICS isn’t even proven as a science… the only thing we know for sure is MICRO.

    Dude, go to the gultch! Let Atlas Shrug. Obama isn’t FDR, when debt service surges up, he’ll be THE President to cut SEIU and raise the age on Medicare…. just like Clinton cut welfare.

  36. Gravatar of Joe C Joe C
    30. June 2010 at 07:17

    Question?

    How can one explain that during the period 1867 to 1879 that, as stated by Friedman and Schwartz, prices declined by half yet this period witnessed strong economic growth? They did not say but I assume employment increased over this period. Was this merely an artifact of monetary system that was in place at that time?

  37. Gravatar of DanC DanC
    30. June 2010 at 08:42

    My Points

    Irish austerity, and a willingness to adjust public payrolls and spending, seems to be working.
    http://online.wsj.com/article/SB10001424052748703426004575338433422665358.html?KEYWORDS=ireland

    Despite Krugman’s attacks.
    http://krugman.blogs.nytimes.com/2010/06/29/a-terrible-ugliness-is-born/

    Recent Irish economic policy

    http://www.irisheconomy.ie/index.php/tag/ireland-fiscal-policy/

    the reference to monetary policy was incorrect, I really just meant the intervention in Irish banks by the Irish government.

    In a hurry, but didn’t they do a good bank, bad bank model takeover. Not sure. In rush to catch plane.

  38. Gravatar of Keith Eubanks Keith Eubanks
    30. June 2010 at 09:58

    @ Doc Merlin

    Here is my line of thinking on inflation being pushed till war’s end.

    First, let’s start with a basic premise that capital accumulation drives economic growth. We can use the Solow Growth Model as a foundation for this: capital and labor working at some technological productivity produce goods and services, most goods and services are consumed, some are saved and invested, if investment is greater than capital consumption (net investment is positive), capital accumulates and production grows. This is the basic mechanism for economic growth.

    According to Friedman & Schwartz (I’m only in the 20s with this), rougly 70% of federal expenditures during ww1 were funded by borrowing. Government borrowing for the war competed with private borrowing for savings. Since war spending was by and large consumption spending (some went for tooling in war industries but most was consumption), the effective savings rate of the country was lowered. In other words, people bought war bonds instead of putting their savings into the bank — this slowed deposit growth and non war investment. When the war was over, people quite buying war bonds and began putting their savings in the bank (and other investments). Deposits grew briskly and the inflation that might have been expected with Fed Reserve financing mostly showed up after the war. Furthermore, the deposits and other investments would start driving capital accumulation, grow production (non-war related) and further the growth of deposits.

    Another way to put this is that during the war, savings were shifted to consumption so deposits couldn’t grow. After the war savings went back to deposits and investments. Since investment drives the real growth rate of deposits, deposit growth re-enforces itself.

    In the civil war, more spending was financed through greenbacks. This meant 1) that much more money was introduced into the economy during the war driving inflation and 2) that financing was more evenly distributed across both savings and consumption.

    Thoughts?

  39. Gravatar of Doc Merlin Doc Merlin
    30. June 2010 at 11:08

    @Scott
    You say it is expansionary, even though they cut the money supply substantially? I understand what NGDP did, but if in this case a cut in money supply was “expansionary” then a fed that did absolutely nothing at all would have been /even more/ expansionary. This strikes me as misuse of the word.

  40. Gravatar of Bonnie Bonnie
    30. June 2010 at 20:48

    @Scott:
    You said:
    “I agree that Harding did an excellent job in 1921-23. He followed relatively laissez-faire policies, cutting taxes sharply. There were no 99 week UI benefits or minimum wage increases. The supply-side was very flexible. In contrast, Hoover did everything wrong.”

    I see your point about supply-side, and I think there’s more to it than extended UI and minimum wage. I’m assuming those were just examples. When I look at the flow of funds reports for 2003-2009 I see at least one real interesting thing. The share of non-farm, non-financial undistributed profit declines from 50% in 2005 to 35% in 2007 while the effective tax rates on same rose from 27% to 30%. Even more interesting is that while the effective tax rate leveled off at 30%, undistributed profits continued to decline.
    This part of it is interesting because if you look at the entire time period, effective tax rates start out at 32% in 2003 with undistributed profits at 0%. As the tax rate declines to the low of 27% for the time period, the share of undistributed profits rises to a high of 50%. I can’t say for certain there’s a correlation there, but I think Art Laffer did some work in this area. It would also be interesting to find out how much of AD is corporate demand.

    I don’t really buy what seems to be the Republican mantra that tax cuts solve everything though. We appear to have some other serious problems that make the future look not so rosy. You can feel relieved that I’ve sort of answered my own question about whether Congress can do something if the Fed refuses to play ball. Whether the Fed decides to play ball or not I think it has some serious work on the supply side to ensure a satisfactory long term outlook.

  41. Gravatar of ionides ionides
    30. June 2010 at 21:06

    Maybe I’m just suffering from creeping, generalized impatience, but it drives me up the wall when economists (or anyone else) use analogies. Why waste our time (and more importantly our attention) talking about airplane engines? Formulate your ideas cogently and express them; that should suffice to get the point accross. Greg Mankiw spent about 25 percent of a recent column talking about doctors, not as a subject for analysis, but as a way of belaboring the notion that a policy may be ineffective either becaused it is the wrong response or because it is the correct response inadequately applied. When you feel impelled to analogize, use it as an opportunity for self-criticism: spend the intellectual energy purifying the exposition, not diluting it with illustrations that repeat the idea as it might appear in another discipline. Impatience is not a response you want to elicit.

  42. Gravatar of dwr dwr
    30. June 2010 at 23:31

    Hey Scott,

    First of all, “Price Flexibility and Employment” by Oscar Lange (1952) says that perfect wage flexibility would not entirely eliminate excess supply of goods or labor. I admittedly have not read it yet– I have only seen it cited–, but this discussion might have inspired me to finally read it soon. This paper, from what I can tell, might be useful in modeling economies with “truly flexible wages,” in Cowen’s words. And it might be useful in determining the mechanism by which Haiti retains a high unemployment rate. Again, I haven’t read this paper (yet), so I’ll refrain from further hypothesizing.

    Second of all, I think it’s fair to say that sticky wages do have real effects. But I don’t think less rigidity is necessarily a good thing.

    Delong and Summers (1986) in their paper “The Changing Cyclical Variability of Economic Activity in the United States” suggested that increased downward rigidity of wages actually decreased the volatility of the postwar business cycle. The idea isn’t new; it dates back to Keynes in his General Theory, and Tobin in 1975 (“Keynesian models of recession and depression”).

    From what I can tell, the mechanisms through which this happens are expectations and price flexibility: in a economy with perfect price/wage flexibility and a floating exchange rate, if all nominal wages drop by (for example) 20%, then (1) prices will drop 20% such that real incomes stay the same, and (2) deflation will create expectations for more deflation, which raises real interest rates, which makes things worse.

    (I deliberately ignored the Pigou effect, which is usually negligible in the real world. Of course, the Pigou effect and its resulting wealth effect makes it so prices drop less than wages. But on the other hand, you have debt deflation and a decreasing velocity of money, so never mind.)

    I wish I had more to contribute, but unfortunately all of my knowledge of price stickiness comes from a project I did on business cycle volatility, and Mankiw’s “Sticky Price Manifesto.” I’m interested in your thoughts, though.

  43. Gravatar of Alex F. Alex F.
    1. July 2010 at 07:05

    “Alex, That would work, but there are easier ways to get the job done.”

    I know you. You prefer negative interest on ER. I agree, they should try that first, it’s just I’m not entirely convinced that people wouldn’t start hoarding currency. I read the older posts and you already discussed this objection. But still…

    “That would also increase the national debt, as taxes would have to be raised to pull some of that money out when a recovery occurred.”

    Why can’t the Fed just raise the federal funds rate or the discount rate or change reserve requirements? I thought the problem is pushing on a string. Pulling on a string should be easy. Why taxes?

  44. Gravatar of Scott Sumner Scott Sumner
    1. July 2010 at 09:53

    dlr, I hope it isn’t a copout to say “both.”

    Remember that real wages are W/P. In a very simple AS/AD model you can think of tight money as reducing P, and government intervention in labor markets as raising W. But I also think that some of the government interventions (extended UI benefits) are themselves caused by the tight money.

    On the other question I’d need to do a lot of reading and thinking to give you a good answer, but my sense is that they use models where prices are sticky in the short run and money works by changing interest rates. In my approach money affects prices and interest rates reflect the level of NGDP, which is determined by expected future growth in the supply and demand for money (excess cash balance approach).

    Perhaps another commenter can find some other distinction. It makes my brain hurt to even think about the IS-LM approach so it’s quite possible that I am missing some important distinctions.

    BTW, I think people tend to see the variable they favor targeting, as the causal variable. Monetarists think M causes AD to change, Keynesians think i causes AD to change. If we started targeting NGDP futures then people would realize that future expected changes in NGDP cause current changes in AD.

    Morgan; You said;

    “But this isn’t an Ayn Rand novel, we have tens of millions of educated likely voters prepared to gut Public Employees and raised age on benefits, trim sails on military, and FORCE Obama to make like Clinton – and balance the budget.”

    I agree with the first seven words of this, but not much else. I fear that the worse things get, the more socialist we get. This remind me of the Cuban trade embargo. The view was that if things got bad enough the people would rise up and overthrow Castro. I’d rather have us help Castro make his economy more prosperous–ESPECIALLY because he doesn’t want our help, knowing a more prosperous Cuba will become more capitalist.

    Joe C. Let’s start with the fact that F&S agree with my central argument, that deflationary monetary policies cause recessions. Second, there was a very tight money policy in 1873, which created a severe recession. Third, the years when prices didn’t fall were more prosperous that those where prices fell. Fourth, there was no positive trend rate of expected inflation back then, delfation was expected and hence wages were far more flexible. There was also an open frontier, which pretty much eliminated the problem of involuntary enemployment. In addition, there were no minimum wage laws, no unemployment insurance, etc. This made labor markets more flexible.

    I do not argue that monetary policy influences RGDP growth over the long run, just the opposite. I beleive in Natural Rate models where money is neutral in the long run.

    DanC, Thanks, I don’t know a lot about the Irish situation. As an outsider it seems to me that the wage cuts mentioned were probably the most effective things they could do. (Assuming they don’t leave the euro.)

    Keith, I agree that Greenbacks were a key in the Civil War.

    Doc Merlin, Which money supply are you using? I thought the base rose? In any case, I don’t consider the money supply to be a good indicator of the stance of monetary policy, and most economists agree with me on that, so it isn’t an odd opinion.

    Bonnie, Yes, there are other things. I suppose there may be fears that the health care bill will raise business costs. And taxes are expected to rise.

    ionides, I appreciate your view, but I find analogies extremely helpful when other economists use them. I find that if I try to state by views in a straightforward way, I am often misundersttod. So I hope that analogies will help others understand the intuition behind my argument better. Perhaps the airplane engine was a bad analogy. But causality is an often misunderstood concept. Many people think the meaning of “causality” is obvious, but in fact it is very difficult to define.

    dwr, I doubt there are any economies with “truly flexible wages”, in fact I am certain there are not. There may be some labor markets within countries with flexible wages.

    You said;

    “Delong and Summers (1986) in their paper “The Changing Cyclical Variability of Economic Activity in the United States” suggested that increased downward rigidity of wages actually decreased the volatility of the postwar business cycle. The idea isn’t new; it dates back to Keynes in his General Theory, and Tobin in 1975 (“Keynesian models of recession and depression”).”

    I once published a paper criticizing DeLong and Summers (actually a slightly different paper they wrote.) I don’t agree with their view. The argued that FDR’s high wage policy helped the recovery. In fact there is overwhelming evidence that it slowed the recovery.

    Their error was in assuming a close connection between wages and prices. Often that is true, but not when the economy is in disequilibrium. And not if the Fed is targeting inflation, which it has been ever since they wrote the article in 1986.

    Alex, You said;

    “I know you. You prefer negative interest on ER. I agree, they should try that first, it’s just I’m not entirely convinced that people wouldn’t start hoarding currency. I read the older posts and you already discussed this objection. But still…”

    No you don’t know me. I’d do NGDP targeting, level targetin,g first. In that case negative IOR probably wouldn’t be needed. A zero rate should be enough.

    On your second question, you suggested that they might want to do large money injections. My point was that if the money stayed in the economy after recovery began, inflation would soar to excessively high levels, which would be completely unacceptable. To prevent that they could raise interest rates, but that could only be done by pulling the money out of circulation. If they originally had given the money away, how are they going to pull it out of circulation?

  45. Gravatar of Morgan Warstler Morgan Warstler
    1. July 2010 at 11:10

    There’s the rub, you look at Depression era people and think we’ll do the same thing again…

    I look at Reagan’s legacy, and think this country is center-right, and will use massive debts as reason to cut back on those with their hand in the till.

    Reagan and Thatcher are what we know, only eggheads talk about the Depression.

    Clinton is more popular than Obama because there’s a grand middle swath, that remember how things got better when Clinton focused on cutting deficit and ending welfare as we know it.

    AND AS SUCH, you need to PROVE your assumption – because your entire plan hinges on a goblin that doesn’t exist:

    We are a smarter people today, we realize our poor aren’t the poor of the ’30′s, we’re ready to bite the bullet and gut public employees.

    See New Jersey.

  46. Gravatar of Doc Merlin Doc Merlin
    1. July 2010 at 11:25

    @Scott
    “Doc Merlin, Which money supply are you using? I thought the base rose?” [in reference to the 1920 recession]

    Nah, the base rose early in the recession then fell by even more than it rose.

    “In any case, I don’t consider the money supply to be a good indicator of the stance of monetary policy, and most economists agree with me on that, so it isn’t an odd opinion.”

    Fair enough.
    ———————————————————
    “BTW, I think people tend to see the variable they favor targeting, as the causal variable. Monetarists think M causes AD to change, Keynesians think i causes AD to change. If we started targeting NGDP futures then people would realize that future expected changes in NGDP cause current changes in AD.”

    And Goodhart’s law would suggest that whichever variable is the important one is the one you are not targeting. ;-)

  47. Gravatar of dlr dlr
    1. July 2010 at 19:35

    Scott,

    Thanks for your response. When I was trying to think about the answer to my question (about rate-centric versus money-centric views) before asking you, I found this Woodford article was the most helpful in helping me start to connect the dots:

    http://www.ecb.int/events/pdf/conferences/cbc4/Woodford.pdf

  48. Gravatar of Scott Sumner Scott Sumner
    2. July 2010 at 05:40

    Morgan, If we are as conservative as you say, why are the Republicans afraid to propose spending cuts? Instead thaey claim that Obama will take away Grannie’s Medicare.

    Doc. I am talking about the recovery. I know the base fell sharply between late 1920 and late 1921, but after that?

    I think Goodhart’s law breaks down if you are targeting the goal variable.

    dlr, Thanks, I’ll take a look.

  49. Gravatar of Scott Sumner Scott Sumner
    2. July 2010 at 05:51

    dlr, I agree that you can control inflation without focusing on monetary aggregates. And as Woodford correctly points out, Milton Friedman also agrees with this.

  50. Gravatar of dwr dwr
    2. July 2010 at 23:22

    Scott, once again, thank you for your valuable input and for taking the time to respond to what I said. It’s very helpful and it means a lot.

  51. Gravatar of Doc Merlin Doc Merlin
    3. July 2010 at 05:33

    “Morgan, If we are as conservative as you say, why are the Republicans afraid to propose spending cuts? Instead thaey claim that Obama will take away Grannie’s Medicare.”

    Right now, Boehner (minority leader) has been pushing to raise the retirement age.

    “Doc. I am talking about the recovery. I know the base fell sharply between late 1920 and late 1921, but after that?”

    It began rising after recovery was under way, and continued rising through the next recession then sort of leveled off after it.

    “I think Goodhart’s law breaks down if you are targeting the goal variable.”

    I disagree here. If we fix the monetary problems through NGDP, the economy will run more efficiently wrt areas that are sensitive to NGDP. However this added static efficiency, this will make the entire economy more brittle wrt regulatory policy. The important variable will be regulatory instead of monetary. It is a better position than were we are in right now, but I think Goodhart’s law would still hold.

  52. Gravatar of ssumner ssumner
    3. July 2010 at 07:35

    dwr, You are welcome.

    Doc Merlin, I don’t think it would affect rsik taking all that much, but as you say we need much more regulatory reform, as I concede that I might be wrong.

  53. Gravatar of Would NGDP Flexibility Bring Our High Unemployment Rate Down? – Christian Forums Would NGDP Flexibility Bring Our High Unemployment Rate Down? - Christian Forums
    22. December 2011 at 06:58

    [...] [...]

  54. Gravatar of Chapter 7 Bankruptcy Chapter 7 Bankruptcy
    2. October 2012 at 06:20

    I am struck by how little attention people pay to their own sticky nominal wage hypotheses. If that were the problem, and if unemployment were today’s biggest issue (a totally plausible claim), you might expect people to blog the micro-foundations of nominal wage stickiness very, very often.

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